The Hocus Pocus CRT: Now You See the Capital Gains, Now You Don't!

Summary

In the cloak and dagger world of the Planned Giving Design Center (we're just kidding) we sometimes receive unsolicited information from concerned gift planners regarding techniques and practices they believe are questionable. In this special article, we share a technique that attempts to use a charitable remainder trust to eliminate capital gains tax. We call it the "Hocus Pocus CRT." Is it a plan or a scheme? We'll let you be the judge.

Perhaps there should be a book entitled, Everything I Needed to Know about Planned Giving I Learned in Kindergarten. Among things like treating donors and charities fairly, one tenet could be not to exploit the tax-exempt status of a charitable remainder trust in an attempt to evade the capital gains tax. We have seen the Accelerated CRT and Son of Accelerated CRT techniques which the Service and Congress promptly exterminated; and yet, here we are again with another scheme brought to you by planners who share the same philosophy: Take the money (i.e., fees) and run; the legitimate uses and continued availability of charitable remainder trusts be damned!

How "It" Works

It has been said, "If it works, it's a plan; if it doesn't, it's a scheme. We will let you be the judge.

According to what appears to be an unsigned opinion letter from an unknown source faxed to the PGDC, this particular version of the story takes place in California. We have also confirmed, however, the plan is being promoted in other states as well.

In order to protect the anonymity of the parties, we have changed the facts slightly. The facts begin with a married couple, both age 55, who owned $10.1 million in publicly-traded securities having a $0 cost basis.

Step 1. Partnership Formed

On January 1, 2000, the couple transferred the securities to a newly formed limited partnership ("LP") in exchange for a 99% limited partnership interest. An unrelated party transferred $100,000 in exchange for a 1% general partnership interest. A 30% minority and lack of marketability discount was applied to the limited partnership interest reducing its fair market value for income and gift tax deduction purposes to $7 million.

Step 2. LP Shares Transferred to NIMCRUT

Later that same day, the couple transferred their entire limited partnership interest to a newly created net income with make-up provision charitable remainder unitrust ("NIMCRUT"). The trust named the couple as the joint and survivor life income recipients of an 8.29% unitrust interest with the remainder interest payable to one public charity. At the time the trust was created, the trustors intended to receive income payments for life and, presumably, by use of the NIMCRUT/partnership combination, create the ability to control both the timing and the amount of those payments. It is represented there was no pre-arranged plan or intention on the part of the trustors to sell their income interests in the trust.

The trustee is an independent party. The charitable remainderman is a public charity; however, it is not stated in the facts whether the trustors reserved the right to substitute the remainderman. Doing so would certainly encourage the charity to play along, as will become apparent later.

Step 3. Charitable Deductions Claimed

By no coincidence, the payout rate of 8.29% was selected because it would maximize the trustors' income while minimizing the present value of the remainder interest at 10 percent. Based on the discounted fair market value of the LP interest of $7,000,000, the trustors claimed an income tax and gift tax charitable deductions in the amount of $700,000.

Step 4. General Partner Sells Partnership Assets

A few days later, the general partner ("GP") liquidated the stock portfolio and reinvested the proceeds in money market funds. The partnership distributed the interest payments to the LP (the trust). These amounts were considered trust accounting income and were, therefore, distributed in partial satisfaction of the unitrust amount.

Fast-forward 23 months to December 1, 2002 and enter the promoters

Step 5. Offer Made to Purchase Income and Remainder Interests

On December 1, 2002, the promoter of this plan, an independent third party that is not a charitable organization described under section 170(c), offered to purchase both the trustors' and charitable remainderman's interests in the NIMCRUT. The purchaser offered the trustors $8 million and the charitable remainderman $1,182,200. The offer to the remainderman was based on the fair market value of the trust's assets (without discount) multiplied by the present value of remainder interest factor, both determined on date of the offer ($10,000,000 x .11820).

Both parties accept the purchaser's offer.

Step 6. Offer Made to General Partner

Concurrent with the other offers, the purchaser offered to buy the GP's interest for $100,000. The GP accepted.

Step 7. NIMCRUT Amended

The trust contains a spendthrift provision, which provides that a beneficiary's interest in principal or income is not subject to voluntary or involuntary transfer. Thus, the trustors, the income recipients (also the trustors) and charitable remainderman amended the trust to delete the provision, which then allowed them to assign their interests freely. The amendment was accomplished in compliance with California Probate Code §15404(a), which permits modification or termination of an irrevocable trust without court petition if the settlors and all beneficiaries agree.

Step 8. Sale Consummated

On December 31, 2002, the independent third-party purchaser, in a single transaction, will conclude the purchases as outlined above. The sale document provides that the trustors will cooperate with the purchaser to terminate the trust. Likewise, the trustee has stated informally that it will not exercise its power to petition the courts to approve any subsequent termination. In January of 2003, the trust will be terminated and its assets distributed to the purchaser.

The Twist

At this point the charitable remainderman has received exactly the present value of the amount to which it would ultimately be entitled and the trustors have taken less than their pro rata share, so where is the potential abuse? Let's see.

Hocus Pocus -- Now You See the Capital Gain, Now You Don't

It is well established under Treas. Reg. §1.1015-1(a) that a charitable remainder trust takes on the adjusted cost basis of capital assets transferred to it1 ; however, in addition, the promoters cite Treas. Reg. §1.1015-1(f) which provides:

If the property is an investment by the fiduciary under the terms of the gift (as, for example, in the case of a sale by the fiduciary of property transferred under the terms of the gift, and the reinvestment of the proceeds), the cost or other basis to the fiduciary is taken in lieu of the basis specified in paragraph (a) of this section.

In other words, when the GP sold the securities and reinvested in money market funds, the promoters assert the capital gain was realized by the trust and the trustee's basis in the partnership was increased from $0 to the amount of the sales proceeds -- $10 million.

The promoters then claim that when the trustors sell their income interests, the trustee's basis of $10 million is prorated to their interests for purposes of determining capital gain or loss.2 In this case, the present value of remainder interest factor at the time of sale is .11820. Accordingly, the trustors' basis in their life interests should be the remainder of the uniform basis, or $8,818,000 (($10,000,000 -- ($10,000,000 x .11820)).

Loophole or Prudent Planning?

Under IRC §1001(e)(1), the seller's basis is, in most cases, ignored when an interest in a trust is sold or otherwise disposed of. Therefore, it would appear the trustors' basis would still be zero. This was held to be the case, for example, in Ltr. Rul. 200152018 in which the income recipient of a charitable remainder unitrust transferred his life income interest to the charitable remainderman as consideration for a charitable gift annuity. However, the facts presented here are different. The promoters cite IRC §1001(e)(3), which provides that IRC §1001(e)(1):

"shall not apply to a sale or other disposition which is part of a transaction in which the entire interest in property is transferred to any person or persons [emphasis added]."

"shall not apply to a sale or other disposition of a term interest in property as a part of a single transaction in which the entire interest in the property is transferred to a third person or to two or more other persons, including persons who acquire such entire interest as joint tenants, tenants by the entirety, or tenants in common."

Indeed, our experts thought the promoters might be technically correct on this issue. But are they right?

The promoters of the plan then go on to suggest that an early termination of the NIMCRUT will not cause a retroactive termination of the trust's tax-exempt status and will not cause a termination tax under Section 507. They further suggest the sale of the trustors' interest in the trust will not constitute a prohibited act of self-dealing under Section 4941; will not be subject to the excess benefit transaction rules under Section 4958; and will not require the settlors, trustee or the purchaser to give notice to the state's Attorney General regarding the sale or subsequent termination.

Comparing the Results

In this case, the trustors' prorated basis in their income interest was calculated to be $8,818,000. Accordingly, in addition to receiving $8 million in cash as a tax-free return of principal, the trustors would also be entitled to claim a long-term capital loss in the amount of $818,000 -- the difference between their basis and the sales price of $8,000,000.

Had the taxpayers sold their stock rather than contributing it to the NIMCRUT, they would have been subject to federal capital gains tax of 20% and California capital gains tax at a rate of 11%. Because state income taxes are deductible for federal income tax purposes, the combined net rate is 30.56%. Therefore, the couple would have paid $3,056,000 in taxes leaving a balance of $6,944,000.

With this plan, applying the same 30.56% long-term capital gains bracket to the $818,000 capital loss, the couple will save an additional $250,000 in capital gains taxes on future sales of long-term capital assets and, assuming a combined ordinary income tax bracket of 50%, already saved an additional $350,000 from the $700,000 income tax charitable deduction that was claimed when the trust was created. Add these amounts to the $8 million in tax-free cash they received from the sale and the total is $8,600,000, an increase of $1,656,000 over the taxable sale.

And what about the promoters? For a total outlay to the three parties of $9,282,200, they receive trust assets worth $10,100,000--a nice profit of $817,800! In fact, in the original proposal, they made about twice that amount.

Other Applications

Are there legitimate uses for the Hocus Pocus CRT?

Other applications for this technique come to mind. Imagine the hundreds or perhaps thousands of retirement NIMCRUTs that were created for the purpose of income deferral and invested in commercial tax-deferred annuity contracts. Given the downturn in the stock market, many of these contracts have experienced significant reductions in value. Because only amounts exceeding basis in the contract are considered trust accounting income when withdrawn, the trust cannot make any trust distributions until the annuity contract is back "in the money."

The Hocus Pocus CRT could solve this problem by cashing the income recipient out of his or her income interest followed by a distribution of the contract upon termination of the trust. The purchaser could then surrender a portion or all of the contract, or maintain it in force for as long as they deem prudent.

Although a partnership was used in the above referenced case, it is not required; nor is a net income payout format unitrust required. Could the plan be used to cash people out of charitable remainder annuity trusts that have lost so much of their value they had no hope of pulling out of their financial nose dive prior to exhausting their assets? At least charity would receive something.

Tax and Legal Analysis

As a matter of public policy, is this plan consistent with congressional intent? Are there other legal hurdles and how might the Service attack it? To answer these questions, we forwarded the plan to three members of the PGDC Editorial Board for their review and comments:

Laura H. Peebles, CPA, PFS is a Director of Estate, Gift and Trust Services with the national office of Deloitte & Touche, LLP in Washington, D.C.

Ms. Peebles made an interesting observation during our conference call stating the regulations under Section 1015 dealing with allocation of basis on the sale of income and remainder interests were implemented in 1956 when there were no tax-exempt charitable trusts. The charitable remainder trust regulations did not come into being until 1972; accordingly, the Section 1015 regulations did not anticipate this type of transaction. Granted, the Service has had 30 years to tackle this issue; however, it has apparently never come to its attention. In addition she states:

"I have reviewed the above structure. Although I do not have enough information to make a final determination under the currently applicable tax shelter regulations (for example, fees received by the promoter), it appears that this structure may be "a transaction subject to listing" under the tax shelter regulations applicable through December 31, 2002 under Section 6112.

Also, under the recently issued proposed regulations that will become effective January 1, 2003, this will clearly fall within the definition of a "reportable transaction" under the tax shelter regulations. It meets one of the six criteria: it creates a loss under Sec. 165 (see Treas. Reg. 1.6011-4T). Once a transaction meets this definition, any taxpayer who has participated in such a transaction will be required to disclose it in their tax return in accordance with 1.6011-4T(d), reproduced below.

(d) Form and content of disclosure statement. The IRS will release Form 8886, "Reportable Transaction Disclosure Statement" (or a successor form), for use by taxpayers in accordance with this paragraph (d). A taxpayer required to file a disclosure statement under this section must file a completed Form 8886 in accordance with the instructions to the form. The form must be attached to the appropriate tax returns as provided in paragraph (e) of this section. If a copy of a disclosure statement is required to be sent to the Office of Tax Shelter Analysis (OTSA) under paragraph (e) of this section, it must be sent to: Internal Revenue Service LM:PFTG:OTSA, Large & Mid-Size Business Division, 1111 Constitution Ave., NW., Washington, DC 20224, or to such other address as provided by the Commissioner.

Lynda Moershbaecher, J.D., M.B.A. is an attorney, consultant and lecturer on matters of planned giving in private practice in San Francisco and San Diego, California:

"As an attorney representing both individuals and charities, I look at ideas such as the Hocus Pocus CRT objectively at first to see if there is any good reason for the arrangement and whether it meets the requirements of the Internal Revenue Code and regulations. Then, if it runs afoul of the law and regulations, as an industry we should let that be known to our donors and clients immediately.

If, however, it meets the requirements of the Code and regs, we must look at the manner in which it is being used in relation to philanthropic planning on both the donor and donee side of the arrangement. If it is being used in a way that makes the donor more of a "taker" than a "giver" we need to determine what to do about it. Clearly we have seen a few prominent examples of this over the last decade with the accelerated CRT and its progeny, the partnership arrangements, etc. Even though it may be legally correct, its application may do more harm to the whole of the industry than it does benefit for the few individuals and planners who employ the technique to their personal advantage.

I have had occasion to talk to some of the planners who promote this type of plan. They have told me point blank that they do not care about the "whole industry." They care about serving their client's interest only and when the IRS shuts down the arrangement, they will find another plan. This is a very callous attitude that quickly harms an entire industry that does so much good in the nation. While the attitude is one of making the most financially for a client, it is narrow-minded and shortsighted.

In this Hocus Pocus CRT arrangement, it appears the law is on the side of the planners and the individuals. In fact, this set of rules could be applied beneficially to situations of loss where the individual needs to get out from under a trust that no longer serves its purpose or is economically unsound. In fact, I am currently representing clients whose CRT is in a disastrous loss situation where this rule could potentially benefit them. Unfortunately, the IRS is likely to change the rules so that people in those situations where the rules are really needed will not be able to take advantage of them.

Meanwhile, it is worth our effort to try to hold a steady course with our own donors and donees so that we make sure we are not adding to the problem by allowing them to fall into this trap. Clever planning does not always end up with clever results for those who try this type of plan."

"As an attorney that represents a host of charitable institutions in their development and planned giving programs, the Hocus Pocus charitable remainder unitrust appears to me to be another "scheme," such as the accelerated unitrust, the son of accelerated unitrust, and charitable split-dollar insurance plans, that attempts to trade on a charity's exempt status to garner substantial tax and financial benefits to individual donors in inappropriate ways while the ultimate charitable beneficiary gets an insignificant benefit.

From a strict policy stance, representing charity, it's not a good idea (perhaps an understatement). Often, when the Internal Revenue Service becomes aware of these plans (schemes?), it issues notices that put a chilling effect on the use of those vehicles but in its zeal then extends the reasoning to other situations that are not egregious.

It may be fair to say that a strict reading of the materials describing the plan and the cited Treasury Regulations, indicate the plan may work -- although the Planned Giving Design Center editors who discussed it also believe that it will run afoul of the tax shelter regulations that become effective on January 1, 2003. And beyond that, although the plan attempts to make the charitable remainderman whole, it does exploit the tax exempt status of the trust to produce an income tax result for the donor that exceeds what could have been accomplished had the assets been sold on a taxable basis without benefit of the trust. That being said, it's a bad idea from a charitable policy viewpoint and charities should not give their support or participate in these plans (schemes)."

Conclusions

Is it a plan or scheme? We think the latter. Were its promoters brilliant, having found a hole in the Code big enough to drive a tank through? Absolutely; but then again, so were those who created the accelerated CRT and its progeny. As for the IRS, if it is not yet aware of the Hocus Pocus CRT, it probably will be soon. And, as in most cases, it may have the last word. From our perspective as gift planners, we would hope they would use a laser beam rather than a hand grenade to cure the abuse of an otherwise good rule.

See Ltr. Rul. 8943056 in which the Service held that where the assets in a trust have been reinvested, a contingent remainderman's basis in his interest, which was to be sold, equaled the total basis in the trustee's hands of the trust's assets multiplied by the appropriate present value factor.back

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Comments

Is someone really promoting this idea? I had looked into this several years ago and rejected it for the following reasons:
1. It clearly is not consistent with the intent of the Regs. As Laura Peebles pointed out, the 1015 Regs (and the corresponding uniform basis Regs under 1014), particularly the portion that allocates the trust's inside basis at the time of a beneficiary's transaction (rather than the trust's original basis) between the income and remainder beneficiary, were promulgated long before the CRT came into existence. The IRS never contemplated that the trust would be able to increase its inside basis without someone paying the resulting tax.
2. Even the technical argument is not free from attack (at least in most cases). Section 1015 applies to the basis of property received by gift. If the income beneficary is the donor of the CRT, he or she never received the interest by gift but instead retained that interest and the Regs don't apply at all.

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